I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

Muni Bankruptcies Set Up War Between Pensioners And Bondholders

In his order this week allowing Stockton, Calif. to enter into bankruptcy proceedings, Judge Christopher Klein admitted he was heading into uncharted territory.

The city’s biggest debt by far is the $900 million it owes CalPERS, the state-run pension system. Yet the city has refused to negotiate a reduction in what it owes CalPERS, even as it seeks significant haircuts from bondholders and other creditors who have lent the city another $700 million. Eventually, Klein said, he’ll have to “get down into the nitty-gritty of the CalPERS situation.”

“And I, at this point, have no clue how that’s going to come out,” he said.

Neither does anyone else. Stockton is just the latest example of what may become a wave of municipalities driven into bankruptcy by a combination of uncontrolled spending and shrinking tax revenue. Bankruptcy is a fairly straightforward proposition when a business goes belly up: A judge oversees the process of determining how much the debtor can pay and how much each creditor will be paid in the reorganization. Chapter 11 even contains a section specifically dealing with the treatment of pensions in bankruptcy.

Municipal bankruptcies leave much more to the imagination. Congress didn’t specify how to handle pensions in Chapter 9 of the bankruptcy code, which was written specifically for municipal bankruptcies, but it did put severe constraints on judges in order to preserve the separation of powers doctrine. Unlike the almost God-like power of judges in business reorganizations, Chapter 9 judges can’t order cities to raise taxes, change their spending policies, or even prevent them from running up more debt.

No court has resolved the central issue in the Stockton bankruptcy, which is whether the promises the city made to its employees and CalPERS rank above the contracts it made with the bondholders who lent it money. Central Falls, R.I. reworked its pension obligations in bankruptcy, but public-employee labor unions have mounted a legal challenge to a state law that would reorganize the pension system, saying pension promises are the equivalent of contracts that can’t be broken. An appeals court in Georgia soon will address another question with multibillion-dollar ramifications, which is whether bondholders who lent money secured by the revenues from specific projects like parking garages and sewer systems can seize control of those assets when municipalities default.

Billions of dollars hang in the balance, both for bondholders and the companies like Assured Guaranty and MBIA that insure municipal bonds. The financial crisis transformed what historically had been regional patterns of default into a nationwide problem, said William Rizzo, managing director at MBIA’s National Public Finance Guarantee unit.

“We’re certainly seeing stress across the country,” said Rizzo, whose company has issued guaranties on some $330 billion in muni debt. “The whole country’s feeling it.”

Stockton filed for bankruptcy in June of last year after it was unable to trim its chronic budget deficits amid a severe decline in tax revenue because of foreclosures and falling real estate values. The city of 300,000 has slashed its police and fire departments. It now has 1.1 police officers per 1,000 residents, less than half the national average for cities its size, and ranks eighth among the Most Dangerous U.S. Cities.

Much of the city’s trouble was self-inflicted, however. In his oral ruling from the bench on Monday, Klein noted that the city’s leaders had allowed rampant “spiking” of pensions, where public employees used a variety of tactics to inflate their last year of pay in order to earn pensions that often exceeded their base salaries. The city also extended lifetime healthcare benefits to workers, and their spouses, who’d been on the city payroll for as little as a month.

Klein cited a “multi-decade, largely invisible or nontransparent pattern of above-market compensation for public employees.”

The city’s CalPERS debt exploded partly as a result of these practices and partly because the pension system’s returns crashed in the financial crisis. That drove up the present value of Stockton’s pension obligations as CalPERS sought larger annual contributions from its members.

“You had large liabilities being created though spiking and generous pensions and on the other hand you had investment returns plunging,” said Lawrence Larose, a partner with Winston & Strawn who is representing MBIA in municipal litigation. “It was a perfect storm.”

Klein ordered the city and its creditors to try and negotiate a plan during several months of mediation but the city walked away from the talks after MBIA and others demanded that it also negotiate changes in its CalPERS debt. In his comments Monday, Klein criticized the bondholders for refusing to budge.

“You cannot negotiate with a stone wall,” he said. “It is a contradiction in terms.”

He didn’t give CalPERS a pass, however: Under Chapter 9, he cannot confirm a plan unless he determines it is fair to all creditors. Still to be determined, he said, is whether the city could cut its expenses further or extract concessions from CalPERS.

“There is a line drawing exercise in which I cannot be precise about how much is good enough,” he said.

Four hundred miles to the south, the city of San Bernardino presents the mirror image of Stockton. The city has refused to pay its CalPERS bill while a judge considers its bankruptcy filing and the pension fund has mounted a vigorous counterattack that is nearly identical to the one the bondholders pressed up north: CalPERS wants the court to reject the bankruptcy filing and shift to litigation to more favorable state court.

Cities have gone insolvent periodically over the decades, and Congress passed Chapter 9 specifically to deal with municipal bankruptcies. But the statute is vague or silent when it comes to the fight among bondholders, trade creditors, city employees and pension funds.

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On the cover page of every prospectus for lease revenue and pension obligation bond issues in California, you can find the boiler plate disclaimer that the bonds are NOT debt within the meaning of the California constitution and that the issuer has NO taxing power to raise taxes to repay principal or interest on the bonds. These bonds are never put to a vote of the electorate. The bond insurers made a mistake by insuring marginal credits with no tax backing for the issues. California mutual funds contain lots of this paper. Do you know what’s in your fund?

The pension funding problem can be traced to the 1999 pension formula enhancements passed by the Democrat controlled state legislature. It was a payback for their support in the 1998 elections. The Republicans were too busy trying to get an anti-gay marriage initiative qualified for the 2000 primary ballot (Prop. 22) to concern themselves with the real Trojan horse. The state law applied initially only to state workers but local governments had the option of giving their workers similar enhancements. One by one counties and cities fell into line. Some could afford the enhancements but many couldn’t. Some of the weakest issuers have already fallen but there are more to come.

Throughout the state, program after program has been cut to enable governments to keep funding their pension payments. Too bad the judge didn’t at least recommend a roll back of pension benefits to their pre-1999 formula.

“. . .pension promises are the equivalent of contracts that can’t be broken.”

Any contract can be broken – if one is willing to pay the consequences.

Given their track record, trusting a politician to maintain the sanctity of a pension promise is akin to believing your lost wallet will still have that $100 bill you kept for emergencies if you should get the wallet back.